If there are any human traders still out there that happen to be reading this, the UK Foresight project team has some news for you : don’t expect to be trading for much longer. Here is what the report had to say: Read Paper Here[2]

“It is reasonable to speculate that the number of human traders involved in the financial markets could fall dramatically over the next ten years. While unlikely, it is not impossible that human traders will simply no longer be required at all in some market roles. The simple fact is that we humans are made from hardware that is just too bandwidth-limited, and too slow, to compete with coming waves of computer technology.”

The UK Foresight project is a group of academics from over 20 countries who decided to get together and study the effects of computer based trading. Lots of familiar academics names appear in the report including the pro-HFT academic crowd of Brogaard, Angel and Hendershott. And lots of the same old, tired defenses of HFT appear in the report: no evidence that HFT increase volatility, liquidity has improved and transaction costs have been lowered. No doubt this report will be picked up by the HFT lobby and their friendly media contacts and waved around telling people that all is well in the stock market.

But the report does raise some major concerns. Two of which are feedback loops and market manipulation.

Six different types of feedback loops are identified: Risk, Volume, Shallowness, News, Delay and Index loops. You can read more about these on page 14 of the report but the bottom line is that many HFT systems are very similar and tend to react to each other when unexpected events occur. The report says:

“The direct link between market outcomes and the fundamental events that ought to act as anchors for valuation has been severed and replaced by a complex web of iterated and nested beliefs.”

“A liquidity shock on one venue that might have gone unnoticed if there was one large centralised exchange can now affect prices on that venue. In normal times, the aberrant price would quickly disappear as cross-trading-venue HFTs buy low and sell high. But in stressed times, the capital of HFTs may be limited, or the HFTs themselves may start to doubt the prices (as happened during the Flash Crash) and refrain from arbitraging. Real-money investors then start to mistrust valuations across the board, and the resulting pressures mean that HFTs no longer contribute to liquidity provision, which makes price divergence across trading venues worse still. And so the shock is transmitted through the network, and its effects are reinforced by positive feedback. Trades and transactions will happen at socially inefficient prices, and mark-to-market valuations can only be done to multiple and illiquid marks. Understanding how to avoid such situations, and to contain them when they do occur, is a topic for further research.”

They must be kidding? They just described how flash crashes happen and then leave it by saying they need further research on how to contain them. We will save you the trouble and all the hours of research with one simple word: Fragmentation. Without fragmented markets and multiple liquidity pools, the situation that is described above does not occur.

There is much more in the Foresight report but we just wanted to touch on one more subject they brought up: market manipulation.

“Negative effects on efficiency can arise if HF traders pursue market manipulation strategies. Strategies such as front running, quote stuffing (placing and then immediately cancelling orders), and layering (using hidden orders on one side and visible orders on the other) can be used to manipulate prices. For example, deterministic algorithmic trading such as VWAP (volume weighted average price) strategies can be front-run by other algorithms programmed to recognise such trading. Momentum ignition strategies, which essentially induce algorithms to compete with other algorithms, can push prices away from fundamental values.”

So, be gone human trader. You are no longer needed as now we have a system in place which has the potential to crash at any time due to feedback loops and where market manipulation “strategies” run rampant. And, luddite, don’t you dare complain or raise objections because technology is always good and always increases efficiency. Right?

Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.